Prepared by Prudential Securities, Inc.

Crude Oil | Heating Oil | Natural Gas

Overview

After a relatively quiet third quarter, the fourth quarter started with a bang as Mideast tensions caused crude oil to lead a strong rally in the petroleum complex. The brief period of bullish euphoria appeared justified considering the unrelenting pace of refinery activity, especially in the United States. Moreover, regular crude oil production problems (maintenance, unplanned problems and potential disruptions) raised emotions and encouraged further buying. However, signs are emerging that suggest prices will return to the low end of the trading range between $19 per barrel and $21. That move will hinge on refining margins, winter weather and global crude oil supply.

Crude oil prices in the third quarter were trapped in a tight trading range that featured pressure on the low side. However, despite several attempts to achieve new lows for the year, the market could not muster enough momentum to break support. Fundamentally, the crude oil supply/usage balance was tight. Numerous production delays (the most notable being Iraq's two-month absence) held down supplies while record refining activity was behind increased usage, thus preventing crude oil stocks from climbing significantly and prices from falling.

There are several international supply issues providing bullish fodder for the crude oil market, and action in futures is beginning to resemble the high-price environment of 1996. Tensions in the Middle East have begun to heat up, and Iraq's own actions are far from predictable (thus adding to supply uncertainty). In Norway, an offshore oil workers' strike is underway. Although only marginally hampering current production, the strike's continuation may impair future supply additions. In South America, the October 26 elections in Colombia have brought renewed and more frequent rebel activity, which has resulted in increased pipeline bombings and related production delays. Compounding the impact of rebel activity have been technological and mechanical issues surrounding the long- anticipated second wave of Cusiana output, further stymieing non- OPEC supply additions. Other headlines that the trade may point to in support of higher prices include potential weather-related curtailments in Mexico's production and a stepped-up labor strike effort in Kuwait.

Record refinery activity, especially in the United States, remains the market's demand feature. Robust product demand in the United States and most other OECD (Organization for Economic Cooperation and Development) countries, are "forcing" refineries to run at extremely high levels. The heightened pace of refinery demand started in the summer and has continued through autumn despite many predictions that it would falter. The refineries are responding to fat margins (i.e., crack spreads) that have been available in both futures and physical markets. Although the crack spreads have weakened early in the fourth quarter, cuts in refinery operations normally lag the lower margins indicated by the futures market. So, even though pressure on margins is beginning to mount (especially in the physical/spot market), crude oil demand should remain strong for the time being, awaiting price pressure in the product markets.

The strong demand seen lately has prevented global crude inventories from rising significantly; indeed, stocks declined in the United States. The reduction in U.S. crude oil inventory of late erased most of the early 1997 gains, and reserves are now hovering near 300 million barrels, a level reminiscent of 1996 when purported just-in-time inventory policies first emerged. At that time, West Texas Intermediate (WTI) crude prices were in the $21 to $27 range. Further threatening inventory levels is a de-stocking mentality that is supported by the market's flirtation with price backwardation.

U.S. Supply/Usage Balance

Even though domestic production this year has been below year-ago levels, the rate of decline has slowed. Last year, U.S. production declined nearly 150,000 barrels per day (BPD) versus year-earlier levels; through the first nine months of 1997, the year-over-year production decline is about 40,000 BPD. The improved rate of decline this year reflects production gains in the Gulf of Mexico that are mitigating ongoing drops in Alaskan output. Indeed, U.S. production might stabilize in 1998, following an additional 75,000 BPD expected from the Gulf in the fourth quarter (from the Mars, Ram-Powell, and Neptune fields); an additional 200,000 BPD is expected from the region next year.

Imports for the first nine months of the year are up more than 6%, or about 460,000 BPD, above year-ago levels. Clearly, higher refinery demand in the face of declining domestic supplies is at least partially behind the import increase; crude runs have increased 425,000 BPD, or about 3% versus year-ago levels, during the same time frame. Meanwhile, net supplies have increased just 420,000 BPD. In total, U.S. crude demand is averaging 14.5 million barrels per day (MBD) while supply (domestic production and imports) is running at about 14.4 MBD for the first nine months of this year. More recently, crude runs have been in excess of 15.0 MBD. This difference explains why U.S. crude oil inventories fell in the third quarter.

U.S. inventories were rising earlier this year, but supply hiccups and strong refinery demand arrested that trend, and stocks are now declining with more regularity, particularly on the West Coast. Stocks near 300 million barrels are relatively low, but when inventory is viewed in relation to usage, the situation appears even more bullish. Assuming daily crude runs of 15 million barrels, the United States is operating with about only 20 days of cover. This implied "safety net" is lower than levels seen the last two years by four to five days. As a result, the significance of potential supply disruptions is heightened and price shocks could occur, especially if tensions flare in the volatile Middle East. A mitigating factor is that PADD I-IV stocks remain well above last year's levels. (The West Coast is contributing disproportionately to the overall tight U.S. supply balance.)

We expect U.S. demand to remain strong through November. Any refinery response to weaker product prices will take time, and thus any impact on the crude oil balance will not be likely until late 1997 or early 1998. Nevertheless, we must stress that the high refinery operating rates spell gloom for the products market, especially heating oil. A weak product market will pull crude oil futures prices down.

After reaching 15.0 MBD of usage, or 98%-99% of capacity this summer, we expect U.S. crude runs to drift lower, toward 14.6 MBD, or 94%-95% of capacity. Such a level would still be about 3%, or 0.3 to 0.4 MBD, ahead of last year's demand. Assuming domestic production of 6.3 MBD in the fourth quarter, the United States will need to import 8.3 MBD of crude oil over the same time. Thus, the question for market participants to consider is: Will global supplies be enough to prevent U.S. demand (25% of world consumption) from forcing international prices higher?

U.S. crude oil imports typically decline in the fourth quarter versus the third quarter and have done so in each of the last three years. The decline seems to be more a function of U.S. crude demand than global supply as refineries often close for maintenance early in the quarter. We believe imports will remain firmly above 8.0 MBD in the fourth quarter, and probably will be between 8.2 MBD and 8.5 MBD, considering global supply and demand forces. Such a level of imports implies potential tightness in the U.S. crude market. Inventory gains remain likely, but would require lower refinery demand (i.e., crack spread pressure) and/or largely uninterrupted supply. Table 1 summarizes the likely effect on inventories given various levels of imports and refinery demand.

International Supply/Usage Balance

Crude oil production gains have once again failed to meet market expectations while demand continues to surge beyond even the most bullish predictions. The biggest culprit behind supply disappointments was the North Sea, which faced delays due to maintenance and overly optimistic start-up schedules. Further compounding the supply picture were unplanned curtailments at existing fields. Had OPEC production not increased steadily throughout the summer, the supply/usage balance would have been even tighter.

Pushing on the supply/usage balance from the other direction was stronger-than-expected demand, especially in the large OECD countries (e.g., the United States, Canada and Germany). More importantly, it appears that demand likely will remain brisk, especially because many refiners had the opportunity to lock in respectable crack spread margins in the futures markets, thus assuring a continuation in the high crude runs at least through November, and possibly longer. Specifically, the International Energy Agency (IEA) is anticipating global demand will average 75.8 MBD in the fourth quarter versus 73.7 MBD a year earlier, or a 2.8% gain. More importantly, this demand level represents a 2.8-MBD increase from third-quarter consumption. The rate of increase is slightly higher than the third-quarter preliminary figures that show demand at 73.0 MBD, which is up 2.8%, or 2.0 MBD, from third- quarter 1996 levels. Despite these healthy quarterly consumption gains, the supply additions (problems and all) still imply growing third-quarter global inventories. The record refinery rates and flat-to-declining stocks in the United States and Europe suggest that additions occurred elsewhere, probably in the "crude held in tankers at sea" category.

As normal, the seasonal increase in demand the accompanies the arrival of winter should tighten the supply/usage balance. For example, assuming OPEC crude oil and natural gas liquids (NGLs) production averages 27.2 MBD and 2.8 MBD, respectively, in the fourth quarter, the IEA's global demand and non-OPEC supply estimates imply demand will exceed supply by just 0.1 MBD. This amount is nominal, but given the uncertainty that surrounds supply, there is potential for larger draws. Thus, we expect that the fourth quarter's crude oil balance could remain tight and limit further stocks additions unless refinery utilization drops significantly. Still, a reduction in inventories would require strong demand and/or more supply problems (e.g., delayed additions or curtailments to existing supplies). Growing product inventories and related margin pressure can curb crude oil demand. Additionally, there are signs that production is growing.

Additional supply gains are likely from both non-OPEC and OPEC sources for the remainder of 1997; global production has been gradually increasing since July. The trend in OPEC production is up, whether Iraq is included or not. Additionally, non-OPEC supply additions continue to loom, even though the market is taking a "show me" attitude about these increases. Some estimates suggest September production was more than 2.5 MBD above year-ago levels, roughly split between OPEC and non-OPEC producers. The gains were concentrated in the United States and Latin America, but higher North Sea output also materialized with maintenance largely completed. Moreover, North Sea loadings began the fourth quarter with a gain of nearly 0.4 MBD versus September levels. The November program was set to exceed the previous month's levels by about 0.15 MBD. Elsewhere, Middle East production also rose, largely due to the stepped-up export pace from Iraq as well as ongoing increases from Venezuela.

Internationally, the potential for supply to exceed demand remains a significant risk for the remaining portion of this year and portends a bearish overtone for 1998. On the demand side, margins in the physical/cash markets are narrowing, and product supplies are mounting. On the supply side, crude stocks are relatively low, but will grow if non-OPEC contributions increase and OPEC's higher output trend continues. The latter assumes a smooth rollover of the oil-for-aid agreement between the United Nations and Iraq in December (a brave assumption in light of Iraq's unpredictable behavior). Frankly, both supply factors have question marks next to them in light of recent history and Iraq's track record for irrational behavior. Another significant risk lies with northern hemisphere winter weather conditions, which are more uncertain than normal due to the El Nino phenomenon. The fate of demand in the fourth quarter of 1997 and first quarter of 1998 are wed to winter weather conditions, and it appears that the bulls will need at least normal temperatures, if not colder-than-normal, to clear out the apparently large distillate inventory held throughout the global distribution system. Given the uncertainty on both sides of the demand/supply equation, volatility seems assured; near-term price direction is not as certain.

OPEC Supply

Three factors have overshadowed the large gains in OPEC production this year: (1) high global demand; (2) lower-than-expected non-OPEC supply additions; and (3) lower-than-expected inventory increases. Indeed, OPEC production continues to expand, even if Iraq's fluctuating output is ignored. The usual cast of characters (Venezuela, Nigeria and Qatar) are behind most of the increase, but other members appear to be joining the party. Purported quota violations by Saudi Arabia, Kuwait and Iran (the biggest proponents of the quota system) should be raising eyebrows. If those increases are accurate, the related rise in governmental cash receipts (from the higher volumes) will be difficult to forego, even if the call on OPEC crude eases.

It appears that all OPEC producers are contributing more than their assigned quota to OPEC supplies. Taken individually, most of the violations are not material; however, when taken as a whole, there is significant overproduction. In addition, internal OPEC demand is rising, thus lowering the amount of crude oil available for exports, providing another incentive to "cheat." The upward creep in output appears unlikely to reverse. All OPEC members except Saudi Arabia and Kuwait allow foreign firms to participate in their exploration and development efforts; even Iran, Iraq and Libya continue to move in that direction despite U.S. and/or U.N. sanctions. Foreign investors do not share OPEC's view for output restraint, and expect a return on their investment. Those returns come predominately from higher output.

Iraq warrants close attention, given the volatility associated with its crude oil exports. The United Nations continues to control Iraq's exports, and that is unlikely to change soon. Iraqi violation of no-fly zones, continued submissions of incomplete information regarding its weapon systems and basically just an overall "bad attitude" will ensure sanctions remain in place for the foreseeable future (especially with Saddam Hussein still firmly in power). Also working against Iraq are recent reports from the new U.N. chief monitor Richard Butler (who replaced Rolf Ekeus) that claim Iraq continues to hide information on its weapon systems, especially biological ones. This has spurred a hard-line, defiant stance by Iraq in which speculation has evolved to suggest the country might end the existing oil-for-food agreement. Therefore, the crude oil market faces significant price risk as it approaches the next biannual oil-for-food rollover meeting between the United Nations and Iraq in December. Rational behavior is not the norm for Iraq, and thus, should not be expected.

Even if the existing 180-day oil-for-food agreement is rolled over in December, Iraq's daily exports will decline given an equal dollar size limit that would be spread over six months rather than four months. Thus, a rollover with no modifications implies exports will drop to 0.8 MBD from about 1.1 MBD. Moreover, higher international oil prices also would reduce export volumes, given the dollar-based nature of the agreement. A note of caution exists for the bullish implications of such a scenario because Iraq and some of its U.N. allies have hinted that the $2.1 billion revenue allotment will be raised to $3.2 billion. We would be surprised to see this increase approved by both the United States and the United Kingdom, but if it is, another 0.3 to 0.4 MBD of exports would result.

It appears that total OPEC production in the fourth quarter should match (if not exceed) the third-quarter level of 27.2 MBD, and thus, remain well above the official quota of 25.0 MBD. The gains are partly due to Iraq, whose revised oil-for-aid agreement enabled it to sell more crude oil in September and October in order to make up the shortfall in revenue caused by the two-month stoppage last summer. We expect fourth-quarter supply to market should average more than 27.2 MBD, a level in line with third-quarter output, due to higher supply from other countries that will offset lower exports from Iraq that ensue following the September/October burst.

In 1998, we see total OPEC output averaging 28.1 MBD (up 1.1 MBD, or 4.0%, versus 1997 levels). This higher level assumes that the United Nations will raise Iraq's revenue limit for the oil-for-food agreement sometime next year; a $3.0 billion allotment implies an increase in Iraq's crude oil exports of about 0.3 MBD. In addition, OPEC NGLs also are expected to show an increase in proportion to the gains in crude oil.

Non-Opec Supply

Preliminary figures from the IEA indicate that third-quarter non-OPEC supply was 44.4 MBD, up nearly 1.0 MBD from the year-earlier level. However, no significant growth has occurred over the last year. Indeed, quarterly non-OPEC production has been stuck between 44.0 MBD and 44.4 MBD since the fourth quarter of 1996. The delays, maintenance problems and snags behind the stagnation appear over for now, but expected and unexpected curtailments should be viewed as the norm rather than the exception. The unstable environments (political, social, military or weather-related) associated with the location of most of the new supply areas almost assure problems will continue in some form.

Global inventories expanded by about 1.3 MBD during the third quarter, when considering global demand of 73.0 MBD and total production from non-OPEC sources (44.4 MBD) and OPEC (crude oil at 27.2 MBD and NGLs at 2.8 MBD). That inventory increase appears high in relation to other reports on third-quarter inventories, but some of these gains may lie in the "tankers at sea" statistics that are difficult to track.

A more significant year-over-year upturn in non-OPEC crude oil production is expected in the fourth quarter. Latin America (Mexico, Colombia and Brazil), the United States and the North Sea are expected to be the main contributors to the rise in output. We are looking for production to rise to at least 45.0 MBD in the fourth quarter, up 0.6 MBD from the year-ago level and equal to apparent production in September. In comparison, the IEA is expecting production to climb to 45.9 MBD, up 1.5 MBD. Such a robust outlook is very optimistic and subject to revision, but the potential is there. Regardless, a tight balance in the fourth quarter and next year's first quarter is likely if demand meets expectations, which are founded on an assumption of normal winter weather conditions.

Global Demand

The IEA expects total world demand in the third quarter was 73.0 MBD, a year-over-year increase of 2.8%, or 2.0 MBD; it expects fourth-quarter demand to reach 75.8 MBD, also up 2.8%, or 2.1 MBD, versus the same period in 1996. In 1998, annual demand is forecast at 75.5 MBD, up 2.4%, or 1.8 MBD, from 1997's projected level of 73.7 MBD; 1996 demand increased 1.7 MBD, or 2.3%, versus 1995. All these rates are well above the historical trend of a 1.5% annual increase in demand.

According to the IEA, 1997 world energy demand has continued where it left off in 1996-rising more rapidly than most have expected. For starters, OECD demand (evidenced by very high refinery outputs) has remained strong. Crude oil runs in these countries averaged 34.5 MBD in August thanks to record operating levels in the United States and strong runs in Western Europe. U.S. product demand was a large contributor to the demand gains, but strength in Canada and Germany also helped easily offset ongoing declines in Japan. These gains in OECD demand are offsetting a dip in growth within the non-OECD sector, due partly to currency weakness versus the dollar.

Both the second- and third-quarter figures suggest that some of the global demand gains were the result of shifting gasoil (heating oil) stocks from primary to secondary holdings in Europe and the United States. In light of this behavior and last year's inventory rebuilding, third- quarter U.S. and European demand may be a drag on OECD demand in the fourth quarter.

We agree with the IEA that total global demand appears likely to expand between 2.5% and 3% for the year, considering strong, albeit slowing, non-OECD demand gains that are running well above 3.0%. Such growth in the non-OECD sector implies total global third-quarter demand was between 72.8 MBD and 73.1 MBD, and should be between 75.5 MBD and 76.0 MBD for the fourth quarter.

Non-OPEC crude oil will be in high demand this quarter given that OPEC production is likely to average 27.2 MBD in the second half of this year and that OPEC NGLs volumes are estimated at about 2.8 MBD. Assuming fourth-quarter demand growth of 2.8%, non-OPEC crude oil output must reach 45.8 MBD to prevent a draw in crude stocks. Even if demand grows just 2.5%, more than 45.0 MBD of non-OPEC supplies will be needed in the fourth quarter. Either level would require relatively snag-free operations at existing fields and on-time start ups of new fields, both of which have proven very elusive, especially of late. Still, non-OPEC production has approached 45.0 MBD several times this year. Additionally, a contraction in margins and/or warm weather would lower demand and thus, the call on crude.

If winter weather is colder-than-normal and forces heating oil demand higher, then the global crude oil market could become even tighter. The strong El Nino suggests a warmer-than-normal winter, but the impact is far from exact. Thus, we do not advise trading off of this loose relationship.

Price Outlook

Crude oil futures are now back in a higher trading range than they occupied in the third quarter, but the factors behind the move (high crude demand, low inventories and supply uncertainties) seem fully discounted. Historically, most sustained advances in the petroleum markets have been led by strong product demand from gasoline and heating oil. Thus, we expect product demand (and the weather that influences it) will be critical price- determining factors for crude oil in the upcoming quarter. The other significant pricing factor relates to supply. The market is taking a "show me" attitude with respect to new supply additions that are supposed to emerge during the remainder of 1997 and throughout 1998. Timely production additions have proven very elusive for the last two years. Moreover, when supply additions were forthcoming, they were often offset by other supply curtailments (either actual, emotional or potential). Overall, it appears that the market's ability to underestimate demand and overestimate supply can continue.

Crude oil futures prices should continue to be well supported until refinery utilization rates turn lower; too many supply risks exist to expect much balance sheet relief from the production side of the equation. The demand side of the equation may provide more concrete bearish pressure. A reduction in refinery crude oil runs can result from margin pressure, turnarounds (i.e., repair/maintenance and reconfiguration work) or operating accidents. To date, the fall turnaround schedule, as reported by the IEA, appears light by historical measures, and is coming to a close in the United States. However, the high operating rates at which plants ran throughout 1997 (especially in the United States), suggests that more down time may be needed than originally planned; however, this will not likely materialize until February/March 1998. Significant cuts in utilization will not come unless margins contract, and that hinges on the product supply/demand balance.

Crack Spreads–From the start of the second quarter through the end of the third quarter, the 3:2:1 crack spread based on NYMEX nearby futures contracts has been at or above $4.00 per barrel. This relatively high margin level has encouraged U.S. refineries to run full out. Robust product demand underlies the high margins. The U.S. gasoline segment started out slow in 1997, but picked up momentum late in the second quarter that has continued ever since. Year-to-date gasoline demand is up 1.6% versus 1996 levels. Distillate demand, aided by steady economic activity, also was buoyant, rising 1.7% through September. More recently, heating oil prices have garnered support, and that has helped keep margins up, even though gasoline values have weakened relative to crude oil now that the peak U.S. driving season has ended.

With the start of the fourth quarter, margins have begun to contract, with the 3:2:1 crack spread falling to about $3.50 before recovering. A further narrowing is highly probable due to anticipated weakness in gasoline as well as an eventual, significant decline in heating oil prices (barring a colder-than-normal winter). The high rate of refinery operations in the United States and Europe portend significant product output that likely will raise inventories and weigh on gasoline and heating oil futures prices. Even though gasoline inventories remain near record low levels, demand is declining and inventories are increasing. Indeed, the high production rate should enable stocks to climb 0.1 MBD to 0.3 MBD. These stock additions should pressure gasoline futures.

Distillate stocks already are considerably higher than 1996's lean level and are about 5.0 million barrels ahead of the five-year average for September. The surplus of 22 million barrels over last year's level, of which 75% is heating oil, was due to summer refinery operations in which high gasoline production resulted in high distillate output. With winter approaching, many firms are reconfiguring their crude oil slates to further maximize heating oil output, thus compounding the burdensome supply/usage balance further. If distillate inventories continue to increase, we expect price pressure for heating oil futures and a related contraction in the crack spread.

Implied Forward Curve–The implied forward curve based on the NYMEX crude oil futures contracts is once again flirting with backwardation. Recent declines resulted in the modest contango, but short-term worries have erased the nearly 30-cent carrying charge that appeared briefly early in the third quarter. Note that prices are all well within the trading range of $17 to $21, albeit on the high end. The range also has been reflected by price levels of the major international crude oil benchmarks. This range has remained largely intact, except for when tensions flared in the Middle East and created a short-term spike in prices in October. Even without the Mideast action, it appears that strong demand, supply problems and relatively low stocks still would have pushed prices toward the $21.00 area. All factors considered, we have not changed our fourth-quarter price target of $19.75 and believe a slight dip in the average quarterly price is possible in the first quarter of 1998.

Trading Strategy

We recommend a bearish trading strategy in crude oil for the fourth quarter. Even though crude oil appears cheap in relation to product prices for gasoline and heating oil, pressure on products will weigh on crude oil prices. However, we expect crude oil to outperform both heating oil and gasoline in the upcoming quarter, even though the complex as a whole will be under pressure. Moreover, prices are poised to increase if colder-than-normal winter weather conditions prevail and/or supply disruptions emerge. Given the market's reliance on both weather and supply, higher volatility is likely.

We expect the NYMEX January 1998 crude oil futures contract to trade largely within a band of $19.00 to $22.00 through termination. An extreme high of $24.00 can be expected if tension in the Middle East results in modest U.S. military action. An extreme low of $17.00 also seems possible if (1) the winter proves significantly warmer than normal in the United States and Europe and (2) crude oil production is relatively problem free.

Specifically, we would look to establish a fresh short position at $21.65 in the January crude oil contract, risking $0.75 and seeking $19.25. If prices decline toward $19.00, we would consider long positions unless the downmove was justified by underlying demand and supply conditions. The crack spreads also appear to be offering attractive trading opportunities. Specifically, consider shorting either the gasoline or heating oil crack spread.

Risk Factors To Our Outlook

Here is a short summary of the major bullish and bearish factors that could change the near-term price outlook for crude oil futures:

Bearish Considerations:

–Continued growth in global product inventories.

–Significant contractions in global refinery margins for both physical and futures markets.

197>Warmer-than-normal winter in North America and Europe (El Nino impact?).

–Continued quota violations by OPEC members (e.g., Venezuela).

–Increase in Iraq's oil-for- aid agreement sales limit (e.g., to $3 billion from $2 billion).

Bullish Considerations:

–Escalation in Mideast tensions or any increase in military/political uncertainty in key oil production areas.

–Additional non-OPEC supply curtailments (e.g., civil unrest in Colombia and Nigeria, Norway's labor strike, North Sea problems, hurricanes, etc.).

–Normal or colder-than-normal winter weather conditions (the earlier the better).

–OPEC rhetoric regarding quota adherence at November 26 meeting.

–Curtailment in Iraq's crude oil exports (current deal ends December 6).

October 23, 1997 Richard Redash and Jim Ritterbusch

Prudential Securities, Inc.

One New York Plaza, New York, New York

Consensus National Futures and Financial On Line Index

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